Risk Management FINA 6211

Interest Rates
Chapter 4
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Risk Management FINA 6211
Types of Rates
Treasury rates
LIBOR rates
Repo rates
2
Risk Management FINA 6211
Measuring Interest Rates
The compounding frequency used
for an interest rate is the unit of
measurement
The difference between quarterly
and annual compounding is
analogous to the difference
between miles and kilometers
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Risk Management FINA 6211
Continuous Compounding
(Page 83)
In the limit as we compound more and more
frequently we obtain continuously compounded
interest rates
$100 grows to $100e
RT
when invested at a
continuously compounded rate R for time T
$100 received at time T discounts to $100e
-RT
at
time zero when the continuously compounded
discount rate is R
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Risk Management FINA 6211
Conversion Formulas
(Page 83)
Define
R
c
: continuously compounded rate
R
m
: same rate with compounding m times
per year
( ) 1
1 ln
/
=
|
.
|

\
|
+ =
m R
m
m
c
c
e m R
m
R
m R
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Risk Management FINA 6211
Zero Rates
A zero rate (or spot rate), for maturity T is
the rate of interest earned on an
investment that provides a payoff only at
time T
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Risk Management FINA 6211
Example (Table 4.2, page 85)
Maturity
(years)
Zero Rate
(% cont. comp.)
0.5 5.0
1.0 5.8
1.5 6.4
2.0 6.8


7
Risk Management FINA 6211
Bond Pricing
To calculate the cash price of a bond we
discount each cash flow at the appropriate zero
rate
In our example, the theoretical price of a two-
year bond providing a 6% coupon semiannually
is
39 . 98 103
3 3 3
0 . 2 068 . 0
5 . 1 064 . 0 0 . 1 058 . 0 5 . 0 05 . 0
= +
+ +


e
e e e
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Risk Management FINA 6211
Bond Yield
The bond yield is the discount rate that
makes the present value of the cash flows on
the bond equal to the market price of the
bond
Suppose that the market price of the bond in
our example equals its theoretical price of
98.39
The bond yield is given by solving
to get y =0.0676 or 6.76% with cont. comp.
3 3 3 103 9839
05 10 15 20
e e e e
y y y y
+ + + =
. . . .
.
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Risk Management FINA 6211
Par Yield
The par yield for a certain maturity is the
coupon rate that causes the bond price to
equal its face value.
In our example we solve
g) compoundin s.a. (with get to 87 6
100
2
100
2 2 2
0 . 2 068 . 0
5 . 1 064 . 0 0 . 1 058 . 0 5 . 0 05 . 0
. c=
e
c
e
c
e
c
e
c
= |
.
|

\
|
+ +
+ +


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Risk Management FINA 6211
Par Yield continued
In general if m is the number of coupon
payments per year, P is the present value
of $1 received at maturity and A is the
present value of an annuity of $1 on each
coupon date
A
m P
c
) 100 100 (
=
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Risk Management FINA 6211
Sample Data (Table 4.3, page 86)
Bond Time to Annual Bond
Principal Maturity Coupon Price
(dollars) (years) (dollars) (dollars)
100 0.25 0 97.5
100 0.50 0 94.9
100 1.00 0 90.0
100 1.50 8 96.0
100 2.00 12 101.6
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Risk Management FINA 6211
The Bootstrap Method
An amount 2.5 can be earned on 97.5 during 3
months.
The 3-month rate is 4 times 2.5/97.5 or 10.256%
with quarterly compounding
This is 10.127% with continuous compounding
Similarly the 6 month and 1 year rates are
10.469% and 10.536% with continuous
compounding
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Risk Management FINA 6211
The Bootstrap Method continued
To calculate the 1.5 year rate we solve
to get R =0.10681 or 10.681%
Similarly the two-year rate is 10.808%
96 104 4 4
5 . 1 0 . 1 10536 . 0 5 . 0 10469 . 0
= + +
R
e e e
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Risk Management FINA 6211
Zero Curve Calculated from the
Data (Figure 4.1, page 88)
9
10
11
12
0 0.5 1 1.5 2 2.5
Zero
Rate (%)
Maturity (yrs)
10.127
10.469 10.536
10.681
10.808
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Risk Management FINA 6211
Forward Rates
The forward rate is the future zero rate
implied by todays term structure of interest
rates
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Risk Management FINA 6211
Calculation of Forward Rates
Table 4.5, page 89
Zero Rate for Forward Rate
an n -year Investment for n th Year
Year (n ) (% per annum) (% per annum)
1 3.0
2 4.0 5.0
3 4.6 5.8
4 5.0 6.2
5 5.3 6.5
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Risk Management FINA 6211
Formula for Forward Rates
Suppose that the zero rates for time
periods T
1
and T
2
are R
1
and R
2
with both
rates continuously compounded.
The forward rate for the period between
times T
1
and T
2
is
R T R T
T T
2 2 1 1
2 1

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Risk Management FINA 6211
Upward vs Downward Sloping
Yield Curve
For an upward sloping yield curve:
Fwd Rate >Zero Rate >Par Yield
For a downward sloping yield curve
Par Yield >Zero Rate >Fwd Rate
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Risk Management FINA 6211
Forward Rate Agreement
A forward rate agreement (FRA) is an
agreement that a certain rate will apply to
a certain principal during a certain future
time period
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Risk Management FINA 6211
Forward Rate Agreement
continued
An FRA is equivalent to an agreement
where interest at a predetermined rate, R
K
is exchanged for interest at the market
rate
An FRA can be valued by assuming that
the forward interest rate is certain to be
realized
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Risk Management FINA 6211
FRA Example
A company has agreed that it will receive
4% on $100 million for 3 months starting in
3 years
The forward rate for the period between 3
and 3.25 years is 3%
The value of the contract to the company
is +$250,000 discounted from time 3.25
years to time zero
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Risk Management FINA 6211
FRA Example Continued
Suppose rate proves to be 4.5% (with
quarterly compounding
The payoff is $125,000 at the 3.25 year
point
This is equivalent to a payoff of $123,609
at the 3-year point.
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Risk Management FINA 6211
Theories of the Term Structure
Page 93
Expectations Theory: forward rates equal
expected future zero rates
Market Segmentation: short, medium and
long rates determined independently of
each other
Liquidity Preference Theory: forward
rates higher than expected future zero
rates
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Management of Net Interest
Income (Table 4.6, page 94)
Suppose that the markets best guess is that future short
term rates will equal todays rates
What would happen if a bank posted the following rates?
How can the bank manage its risks?
Risk Management FINA 6211
Maturity (yrs) Deposit Rate Mortgage
Rate
1 3% 6%
5 3% 6%
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